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Annie's, Inc. (NYSE:BNNY)

F3Q2014 Earnings Conference Call

February 10, 2013 5:00 p.m. ET

Executives

Ed Aaron – SVP of Strategic Planning and Investor Relations

John Foraker – Co-Founder, CEO

Zahir Ibrahim – CFO

Analysts

David Palmer – RBC Capital Markets

Chris Growe – Stifel Nicolaus

Bill Chappell – SunTrust Robinson Humphrey

Ken Goldman – JPMorgan

Robert Moskow – Credit Suisse

Jon Andersen – William Blair & Company

Mitch Pinheiro – Imperial Capital

Scott Van Winkle – Canaccord Genuity

Operator

Good day, ladies and gentlemen, thank you for standing by. Welcome to the Annie's, Inc. Third Quarter Fiscal 2014 Earnings Call. [Operator Instructions]

This conference is being recorded today, Monday, February 10, 2014.

I would now like to turn the conference over to Mr. Ed Aaron, SVP, Strategic Planning and Investor Relations. Please go ahead, sir.

Ed Aaron

Thank you, Damien [ph]. Good afternoon everyone. Thank you for joining us for Annie's fiscal 2014 third quarter conference call.

With me today are CEO, John Foraker, and CFO, Zahir Ibrahim.

As we begin, let me remind everyone that statements made during this conference call that are not historical facts, including any statements about the company's targets, beliefs, plans, opportunities or expectations, such as expectations regarding full year and fourth quarter fiscal 2014 results, expectations for fiscal 2015, growth prospects, costs, competition and the planned acquisition are forward-looking statements and are based on management's current plans, known information, estimates and projections. Our actual results may differ materially from those projected in these forward-looking statements and you should not rely on these statements as an assurance of future events or results. Annie's does not undertake to update any of these statements in light of new information or future events.

Forward-looking statements involve inherent risks and uncertainties. There are a number of factors that could cause actual results to differ materially from those contained in today's forward-looking statements, including the risks and uncertainties described in today's press release and the Risk Factors section of our filings with the SEC, including our most recent annual report on Form 10-K and quarterly report on Form 10-Q. These risks include risks related to competition, new product introductions, our growth strategy, our planned acquisition of the Joplin plant, our brand reputation, product liability claims, recalls and related insurance proceeds if any, economic disruptions, changes in consumer preferences, ingredient and packaging cost and availability, reliance on a limited number of distributors, retailers, contract manufacturers and third-party suppliers and on an outside warehouse facility, efficiency projects, intellectual property and related disputes, regulatory compliance, transportation, supply chain, inventory levels and seasonality.

With that I'd like to turn the call over to our CEO, John Foraker. John?

CEO:

Thank you, Ed. Hello everyone and thanks for joining us today to discuss our third quarter financial results.

For the quarter we reported adjusted diluted EPS of $0.17, largely in line with our expectations. From a top line perspective, Q3 was another strong growth quarter for Annie's. Adjusted net sales grew 22% and consumption grew even faster at approximately 24%. As expected, adjusted EPS grew at a slower rate than net sales due primarily to higher organic lead costs and significant SG&A investments that we are making to enhance organizational capabilities. These factors mask strong underlying operating performance and solid cost control.

As our sales results demonstrate, Annie's is clearly benefiting from favorable macro trends in natural organic food. More than ever consumers are seeking to avoid artificial and synthetic ingredients, looking for more positive nutrition and seeking organic and non-GMO options. As a result, they're gravitating towards trusted natural organic brands like Annie's.

Q3 marks our fourth consecutive quarter of accelerated consumption growth as we continue to benefit from strong secular trends, growing brand awareness, progress with our main line distribution initiatives, and successful innovation. These sales trends also demonstrate our strengthening organizational capabilities and validates the significant investments we're making in the business, especially in the area of people.

We continue to see strong consumption growth in each of our primary sales channels, which is a sign of fundamental health and reflects our disciplined channel management. The acceleration in our consumption growth rate in the quarter was driven by a further strengthening in the mass and club channel.

In grocery, we maintained our strong growth trend in the quarter as our main line initiative continues to generate both expanded distribution and higher velocities. And in the natural channel we saw a continuation of double-digit consumption rate.

From a category perspective, we experienced further strengthening in mac and cheese helped by continued base business momentum and strong consumer acceptance of our new microwavable cups. Our flagship purple box mac and cheese continues to perform exceptionally well as we benefit from expanding main line distribution. In fact, our grocery ACB for this product reached the 70 mark for the first time in Q3, a milestone that we hope to build on in the future.

We are well into the trial and repeat cycle for cups and the results are encouraging. So far cup sales have been highly incremental to our boxed mac and cheese business and we're also seeing strong velocity trends on these items. In fact, in conventional retail accounts where we have distribution of cups, our mac and cheese retail sales grew in excess of 30% in the quarter while outpacing our overall growth. This provides a great fact-based telling story which we expect will lead to further distribution wins in the coming months.

While mac and cheese drove the majority of our growth in yields, our frozen business also contributed. Pizza continued to perform very well in the natural channel. Traction in grocery is building more slowly than we would like, as we discussed over the past few quarters. But we understand the drivers and are working to improve our opportunity here. We see incremental progress in our efforts to build trial through enhanced retail execution, sharp [ph] pricing and merchandising events.

Our frozen entrees are performing well and we're beginning to carefully expand into other retailers in natural and grocery. Consumer feedback is positive and we're focused on building trial and awareness to further develop our presence in this category.

In snacks, we continue to see excellent trends in our fruit snack business across all channels. We're also continuing to make solid progress with developing our snack franchise in the grocery channel where consumption of fruit snacks, crackers, Grahams and granola bars all grew at least 20% in the quarter.

As we discussed on past calls, we are positioning ourselves to capitalize on what we believe is a significant long-term growth opportunity in snacks. Consumers constantly tell us they want to see us in more snack categories with more variety and better availability. This quarter we will begin the selective rollout of our new bagged snack packaging for cookies, crackers and snack mix. This flexible and resealable packaging is significantly preferred by consumers, provides a better entry price point, and offers significant potential for increased mainstream distribution.

The team's execution of this project has been terrific. Following a very successful test last quarter, our full assortment of bagged snacks has been accepted by a large national retail customer and will be cut into shelves in all stores in early March.

Another exciting initiative is our focus on expanding distribution of our granola bar line, which we've significantly upgraded through product reformulations and our recent launch of new gluten-free SKUs. Our new gluten-free bars started shipping in December and are up to a very fast start at retail. These are just a couple of examples of the many ideas we're working on to unlock our opportunity in snacks, so look forward to continued news from us in this area.

Our operations team is working hard to improve our cost structure and manage the rapid pace of growth and change in our business. In the third quarter the team executed well in the face of high inflation, driving solid productivity improvements and making good progress in managing aged inventory.

While I'm pleased with the overall execution in these areas, we have revised our full-year EPS outlook to reflect higher expect costs in the fourth quarter, primarily resulting from two factors. First, input costs for Q4 are attracting higher than we originally expected due to continued upward pricing pressure in the organic wheat market where supply conditions remain tight. Last year spring wheat crop, while abundant, was not released by farmers as quickly as we expected, which in turn is impacting availability and pricing in the short term. While supply conditions remain tight, we've taken efforts to improve our visibility by partnering closely and creatively with our supply chain partners. As a result, we believe we have good visibility into our wheat cost through the first half of fiscal 2015.

Second, while we still expect to deliver strong productivity gains from our fat rabbit initiatives in Q4, these expected benefits are not quite as significant as we previously expected due to timing factors related to certain productivity projects which are more likely to benefit us in the first couple of quarters of next fiscal year.

While resetting expectations is never easy, I'd like to underscore that our growth trajectory remains strong. Despite the impact of a later Easter holiday and higher expected cost pressure, we still expect to deliver adjusted EPS growth of around 20%, if not higher, in Q4. We'll be giving guidance for fiscal 2015 when we report our fourth quarter, but I'd like to offer some high-level perspective on our growth outlook for next year.

We see our top line momentum continuing as we execute our main line initiative, introduce compelling new products in both shelf stable and frozen and reinforce our brand leadership through highly targeted consumer marketing programs. Operationally we're working to drive leverage in the business while supporting continued investments in infrastructure and great people. The team has a strong slate of productivity initiatives in the pipeline for next year and is diligently preparing for the integration of the Joplin acquisition which is expected to close in early April. Our transition planning is proceeding well and we remain excited of the many opportunities this plant will give us to drive growth in our snack business.

Before turning the call over to Zahir to discuss our financials in more detail, I'd like to take a moment to commend the terrific impact Zahir has already had on our business. He's strengthening our game, elevating the team and laying a foundation that will serve us very well as we continue to grow the business. He's been a great addition to our team.

With that, I'll turn the call over to Zahir. Zahir?

Zahir Ibrahim

Thanks, John, and thank you for joining us today as we report our fiscal third quarter results. As a reminder, to provide better visibility into our normal operating performance, we are discussing adjusted financial results today, which excludes the impact of the pizza recall as well as costs associated with the planned Joplin acquisition on secondary offering. Adjusted EBITDA also had [ph] the effect of stock-based compensation. Reconciliation between our U.S. GAAP and adjusted results can be found in our press release and are also available in the Investor Relations section of our website.

Now turning to third quarter performance. For the quarter we delivered adjusted diluted EPS of $0.17 versus $0.15 last year. Adjusted net sales were $46.1 million for the quarter, up 21.7% over the third quarter of fiscal 2013. We are pleased with our net sales performance considering that Q3 marked our most difficult growth comparison of the year. Volume was the driver of our year-over-year growth. Higher prices contributed approximately 1 point to adjusted net sales growth and reflects a more modest price increase that took effect on October 1, 2013.

Growth in the quarter was again led by our meals business which grew approximately 34% on an adjusted basis. While mac and cheese was the primary driver, frozen products also contributed to growth. Our snacks business grew approximately 15%, driven by fruit snacks performance. Net sales of dressings, condiments and others were flat with the prior year but grew mid-single digits on a consumption basis. While customer mix shifts were less pronounced than in the first half of the fiscal year, our growth remains strongest in conventional channels, especially mass and club. Net sales to the natural channel returned positive growth in the quarter as all the order patterns from our largest customer began to normalize.

Turning to profitability, adjusted EBITDA for the third quarter was $5.6 million, up 8% over the prior year. Adjusted gross margin for the quarter was 38.7%, down 170 basis points versus last year's third quarter, representing solid improvement against our Q2 performance. Consistent with our expectations, we experienced margin pressure from organic wheat inflation and tight supply conditions, and to a lesser extent, our inventory obsolescence. These headwinds were partially offset by pricing and cost savings from our fat rabbit productivity initiatives.

Adjusted selling, general and administrative expenses improved slightly as a percentage of net sales. Our strong top line growth and diligent cost control efforts provided the best quarter of G&A leverage since the IPO, and that despite continued investments in people and impact of increase to our [indiscernible] cost as a result of large accelerated filer status [ph] for this coming fiscal yearend.

A timing-related increase in marketing spend and higher freight and warehousing costs prevented this benefit from flowing through. Nevertheless our underlying performance demonstrates a long-term leverage opportunity in the business.

Our tax rate in the quarter was 40.1% on an adjusted basis compared to 40% for the last year's third quarter. Diluted shares outstanding were $17.4 million, down from $17.8 million in last year's third quarter due to the repurchase of 500,000 shares completed in March 2013.

Turning to our updated fiscal 2014 financial guidance. We've narrowed our full year adjusted net sales growth outlook to a range of 19% to 19.5%, while revising our adjusted diluted EPS guidance to a range of $0.92 to $0.93, about $0.05 lower than previously anticipated.

On a year-to-date basis we've generated adjusted net sales growth of 20.3%. Consistent with prior expectations, we expect adjusted net sales growth to moderate to mid to high teens in the fourth quarter due to the impact of the later Easter holiday. Based on our updated cost outlook, we now expect our full-year operating margin to decline in the range of approximately 40 to 70 basis points. We expect year-over-year operating margin improvement in the fourth quarter, with strong SG&A leverage offsetting year-over-year gross margin pressure.

Turning to the balance sheet, our financial position remains strong with no debt at quarter-end. As is usually the case in Q3, operating cash flow declined in the quarter due to a seasonal increase in working capital. We anticipate a positive cash flow quarter in Q4 as we benefit from strong profit contribution and inventory reductions.

With that, I will turn it back over to John for his concluding remarks. John?

John Foraker

Thanks, Zahir.

I've never been more confident in the long-term growth outlook for this business. We have a highly authentic and powerful brand, positioned right where consumers are moving in large numbers across all channels. There are tectonic shifts happening in our space and in the broader retail environment as millennial consumers drive more and more purchase decisions for families. These consumers seek natural organic foods, high levels of transparency, digital engagement, and trusting relationships with the brands that show their values.

As an organization, we're well-positioned to execute at a high level. Since beginning our journey as a public company nearly two years ago, we've continued to grow the business while never losing sight of our mission and values that is a source of our authenticity, and the foundation of our deep-trusting relationships with consumers. We've made significant improvements in the business, particularly over the past year, in our people and our systems, so that we can scale the business and execute in a high growth environment for years to come. Our organization is rapidly evolving, constantly learning and improving every day. We are in the right spot for continued success and I'm confident in our ability to deliver strong financial results.

We look forward to finishing the year strong and to updating you on our thoughts for the coming year in conjunction with our fourth quarter earnings release in late May.

I'd like to now open the line for your questions. Operator?

Question-and-Answer Session

Operator

Thank you, sir. We will now begin the question-and-answer session. [Operator Instructions]

Our first question is from the line of David Palmer with RBC Capital Markets. Please go ahead.

John Foraker

Hey, David.

David Palmer – RBC Capital Markets

Thanks. Good evening guys.

John Foraker

Hi, David.

David Palmer – RBC Capital Markets

Hey, John. With many changes in your guidance, it seems to be either timing related or one-time in nature, and I think this is true for fiscal 2014, in general you had some issues, for instance inventory obsolescence is not new to this quarter. As you see, I know we're not getting into fiscal 2015 guidance right now, but just thinking about the thinking about it generally speaking, are these -- are many of the things that you're talking about here that are driving on into the fiscal fourth quarter things that essentially become easy comparisons, going to be mainly more of a margin tilt upward into 2015?

John Foraker

Okay. Why don't you go ahead and I'll finish.

Ed Aaron

So David, it's Ed here. So a couple of -- the two factors that we called out specific to the fourth quarter, one, the wheat inflation, and the second, some timing changes in expected productivity gains. On wheat, we've been dealing with high wheat inflation, you know, pretty much all year. We do have much better visibility now through the first half of next year. We haven't seen improvement in cost there, but at least we have a good visibility for the next call it nine months. Beyond that it's a little bit of an open question as to what happens with wheat costs in the back half of next year.

As far as the productivity numbers are concerned, we do view the Q4 shift as more timing related, so we would expect to benefit from that in the early part of fiscal 2015.

John Foraker

And on obsolescence which you mentioned, which is really a Q3 -- our Q2 and Q3 phenomenon, we basically come in a little bit better than we had expected and implied on our last conference call. So we've significantly improved our processes internally, and we expect obsolescence to be much less of a backburner business than it had been this year.

David Palmer – RBC Capital Markets

On that front, do you think that -- are you making changes internally to -- that you think will help you get a better handle on cost in general? You know, could you give us a flavor of maybe the changes that you're making that could help you better predict your margins going forward?

John Foraker

Yes. So in a couple of areas -- let me comment. So first in the area of total commodities. You know, we buy a number of big commodities. Wheat is one of our biggest, cheese, oil. We have good visibility on these other commodities. And historically we've had ten-plus years of being a pretty major buyer in the organic wheat market and there are common relationships to conventional wheat pricing that have historically held really true. And on a year-over-year basis, right now conventional wheat costs are down anywhere from 15% to 30%, depending on which product you're talking about. And in that environment, we've typically seen wheat costs drop on the organic side with a six to nine-month lag time.

And this year that really didn't happen the way it has played out historically, which was a surprise to us. So what we've done in the wheat area is we've gotten creative and very strategic with our partners. We're looking at new geographies, new supplier relationships, and really expanding our breadth to give us the ability to have a better forward visibility with respect to that commodity. And I think just in general, getting much more sophisticated with respect to looking forward, planning, and setting the expectations right so that we have a really good purview of what our margins are going to look like on a more consistent basis.

And then, Zahir, is there anything you want to add to that from just overall planning perspective?

Zahir Ibrahim

Yes, sure. You know, I suppose from a forecasting perspective, it's a journey that we're continuously on, striving to improve the way we do our forecasting. Forecasting is a tricky area for most businesses, and we're no different, especially given that we're such a rapidly expanding business. But we focus on this area in terms of resourcing and processes and it's an area that we'd look to improve on in the coming months.

David Palmer – RBC Capital Markets

Okay. Thank you.

Operator

Thank you. Our next question is from the line of Chris Growe with Stifel Nicolaus. Please go ahead.

Chris Growe – Stifel Nicolaus

Yes, good evening.

John Foraker

Hey, Chris.

Chris Growe – Stifel Nicolaus

I just had a question, to better understand some of the comments you made, John and Zahir, around the wheat market. We've seen, you know, cheese costs up of late. Having better visibility into your input costs in next year, I guess we should still assume they're going to be up though, is that the correct way of looking at it? And I guess I'm trying to understand the pricing in relation to that cost inflation, is that mostly offsetting it or is it more than the pricing currently?

Zahir Ibrahim

So let me start off with overall input inflation. So from our perspective, while we'll give obviously more formal guidance when we have the conversation in the next call, we view that our input inflation on the whole is going to be more modest in fiscal 2015 than this year. Then you can look at it across different categories, but specifically talking about wheat, you know, we have wheat inflation in the mid to high teens in Q3. We'd expect that to be slightly lower in Q4 for this year. And then we'd expect it to be at similar levels certainly in the first half of next year. After that it depends on how the supply situation progresses, but you could expect some easing in the second half of next year.

Specifically on cheese, we're currently covered from a supply perspective for the first half of next year. If you look at the futures market for cheddar block cheese where we're looking at prices beginning to come down a bit in the second half of next year as well. So that's how I'd position it, more modest inflation for next year.

John Foraker

And then base fee[ph] to that, Chris, so we haven't made our final pricing decisions for next year. I think it's fair to say that when we were going into this year, we were more cautious and conservative in how much pricing we were going to put through, because we were doing so against the context of conventional commodities that were coming off fairly significantly. And we have very strong underlying consumer velocity trends across all channels in our core businesses, and so we want to be cautious with how much pricing we're trying to put through in that backdrop.

So we believe we could take more pricing. We haven't decided what and where to take it, and we're just going to be very strategic to make sure that we remain competitive and that we don't create any real slowdown with the consumer where we have a lot of momentum right now. So that's how we'd characterize our view on pricing.

Chris Growe – Stifel Nicolaus

Thank you. It's good color. I just had one quick follow-up, which is to -- asked the last couple of calls. Just to understand about the promotional spending across the business. So you had some work to do [ph] I know on the pizza business still. Just to understand, in the face of an obvious competitive product launch, if you've gotten more aggressive as well behind the base fee [ph] on mac and cheese business?

John Foraker

So our spending has been very consistent over a long period of time in trade [ph]. Over recent periods we've spent a little bit more in marketing as we called on this call. I would say the way to think about our past year from a competitive standpoint is we're very focused on watching the competitive activity on the categories. There's one, you know, well-publicized launch that's going on in the mac and cheese business now. We remain very confident that we're going to be able to continue to grow despite that threat. We have 25 years of experience and leadership, innovating as really the national organic leader in that category. That entrant came into the market kind of in the late December, early January timeframe, and a couple of big chains and one large national retailer specifically, and they've been very aggressive.

We've been very disciplined but competitive as well. We've seen very little if any impact in our baseline volumes despite very competitive entry price points. So we're confident in our ability to compete. We'll remain disciplined. We don't think that we're going to need to do anything outlandish with respect to our spend rates. But on a customer by customer basis, we're certainly going to remain competitive so that we can continue to drive leadership, category growth and profitability for the retailers we do business with.

Ed Aaron

One thing to add on to that, Chris, so if you look at from a consumption standpoint, our mix of sales in terms of promoted versus non-promoted, we skew very heavily to a non-promoted volume. So our business is very healthy in that respect.

Chris Growe – Stifel Nicolaus

Yeah, it's very helpful. Thank you.

Operator

Thank you. Our next question is from the line of Bill Chappell with SunTrust Robinson Humphrey. Please go ahead.

Bill Chappell – SunTrust Robinson Humphrey

Thanks. Good afternoon.

John Foraker

Hi, Bill.

Bill Chappell – SunTrust Robinson Humphrey

I guess three quick ones. One, on the snack side, you talked about I think Grahams and crackers and fruit snacks, and maybe something else, as all about 20% within the category, was up 15%. So what were the laggards kind of pulling that down?

John Foraker

We were specifically calling out in grocery, in the grocery channel, that those four categories, granola bars is the other one, and the consumption was up about 20%. We got a little lower consumption growth in some of our other retailers, but -- and which accounted for the difference. But overall we're seeing strong consumption growth in snacks across all categories, just a little stronger in some places than others.

Bill Chappell – SunTrust Robinson Humphrey

[Indiscernible] I understand there's been a lot of forced [ph] questions about the kind of natural or supernatural channel slowing down over the past few months. Have you seen that in kind of your business or seen the grocery kind of -- traditional grocery pick up and the others slow down?

John Foraker

You know, we really haven't seen that in our business, in the component of the natural channel that you would typically think of, we've not seen any such evidence than in fact we've seen some pretty strong consumption recently in that channel. So that's not our experience.

Bill Chappell – SunTrust Robinson Humphrey

Okay. And then third is, and you may have done this, but if I'm looking at the $0.05 lower guidance, what's the kind of breakout of pushed-out productivity versus higher commodity [indiscernible]? Is it 50/50 or is it more one than the other?

Zahir Ibrahim

Yeah, I mean it varies through the main drivers, and that's pretty even in terms of their impact.

Bill Chappell – SunTrust Robinson Humphrey

Okay. And actually, sorry, I have one more question. If I look at one of the things of the new competition on mac and cheeses, I think it's organic, and so this -- with the rising organic wheat prices and inflation, does that put you in a disadvantage of having to change price gaps between you versus, not just that [ph], but all the non-organic type products?

John Foraker

The two biggest parts of our mac and cheese business are -- the biggest part is made with organic position product which is organic wheat and natural rbST-free dairy. That's the biggest part of our business. And then we have a certified organic business over the top of that which is certified organic cheese.

So we have a couple of different price points and positioning stake out in that category. And we think that we're going to be able to be competitive. We certainly think relative to competitors that could come in, that we've got a good cost structure and that we should be competitive going forward. And ultimately we really think we're going to win long term because we think we have a very strong brand, we've grown the category, retailers are making a lot of money on us. And most importantly, we have extremely loyal consumers whose needs are being met very well in the category. And ultimately that's the biggest determinant of whether a new competitor is going to be able to really gain ground.

Bill Chappell – SunTrust Robinson Humphrey

Thanks for the color.

John Foraker

Yup.

Operator

Thank you. Our next question is from the line of Ken Goldman with JPMorgan. Please go ahead.

Ken Goldman – JPMorgan

Hey. Thanks for the questions.

John Foraker

Hi, Ken.

Ken Goldman – JPMorgan

John, you talked about the competitive offering out there. Is there anything unusual, we're not seeing it, I'm just curious if you are, in terms of the promotional activity with the percent price discount maybe from these competitors, or is it pretty much as you expected with a launch like that?

John Foraker

It's as you'd have expected. You would expect somebody to come in and get a bunch of display, get a bunch of trial driving very aggressive entry price points to try to stimulate trials. So there's really no difference from what we expected. And we've been aware of this launch now for quite some time and had a long time to prepare for it.

Ken Goldman – JPMorgan

I'm sorry.

John Foraker

And the other thing is that, you know, we, as I mentioned in my earlier comments, we, in the face of that kind of very aggressive entry price point, we've seen very strong, stable baselines in our business, and really so far very little impact on our business whatsoever.

Ken Goldman – JPMorgan

Right.

John Foraker

So I would still say we're early in the game. We're taking the threat seriously as we always have and as we've always taken any competitive threat from big CPG. But we feel like we're well-positioned to win, we just got to stay at it.

Ken Goldman – JPMorgan

And a couple more if I can. It looks like your working capital as a percentage of sales continues to rise, not just because of seasonality but also year on year. I realize some of it's inventory, but the receivables have been creeping up a bit. Could we talk a bit about what's driving that and how we might model that trend going forward?

Zahir Ibrahim

Yes, sure. The way I'd start off, I mean the driver of our Q3 balance sheet at the end of the quarter is, you know, we had higher sales in December, so we had a stronger December this year versus last year, and that was the main driver of that position from an AR perspective. I would say when you look at working capital overall, this is an area that we're going to focus on from a business perspective. We're looking to set some targets going forward, and then putting into place strategies to try and deliver to those targets. But as you can well understand, with working capital, this is not something that you can change overnight. It's something that will take a while to do so. We're going to go on that journey over the coming months.

Ken Goldman – JPMorgan

Okay. And then lastly, as you think about some of the drivers of the gross margin pressure this year, how might you rank them in order of importance? And I'm asking because, as I think maybe David Palmer implied, so a lot of the expenses were obsolescence and changes in supply chain, it seemed somewhat one-time in nature to me. So assuming all else equal or maybe even less of a headwind from commodities, wouldn't that imply somewhat of a nice gross margin rebound next year, or am I thinking about, you know, the nature of some of these costs, I don’t know, a bit too constructively?

Zahir Ibrahim

Yeah. I mean you've got every right to ask the question, right? And the way I'd articulate it is, yeah, for sure inventory obsolescence this year did have a couple of unusual items in there, but with our business of our size, we will have some normalized level of obsolescence. You'd have to assume that some of that is not baked into our margin, so it shouldn't be a year-over-year drag. Obviously reports about [ph] wheat inflation and where that's at right now and where it's going to be for the first half of next year. So that'd be the key components in terms of how you'd think about gross margin.

John Foraker

I think, Ken, just to build on the obsolescence comment, I think there is some in our baseline, but I do think on a year-over-year basis this year does have some one-timey feel to it, because the internal processes have been significantly remapped, and historically as the company grew over the years prior to this year, we really managed that part of the business better than we had done this year. So I would just add that.

Ken Goldman – JPMorgan

Thanks, John, I appreciate that.

John Foraker

Good.

Operator

Our next question is from the line of Robert Moskow with Credit Suisse. Please go ahead.

Robert Moskow – Credit Suisse

Hi. John, as you and Zahir try to figure out together what the normal level of obsolescence, you know, my view is the business is becoming more complex, you're introducing a lot more SKUs in a lot of different parts of the store. I would encourage you to bake in a conservative level of obsolescence going forward just to prepare for the worst. And so that's more editorial.

The second point I would bring up, the organic wheat visibility, three months ago you brought up organic wheat, the tight supply conditions. I just don't understand what's changed in the last three months in that regard. Certainly you saw it coming, you knew it was going to be hard to get your hands on enough that you wanted. So what changed in those three months? Were you expecting a regression to the mean over a course of three months and it just didn't happen?

John Foraker

We were expecting prices to break certainly, and we were expecting higher wheat costs which we did call out last quarter. But we were expecting, on the heels of a really nice spring crop for pricing to break early in the year. And we've been doing this now for about 10 years as a significant buyer in this marketplace. And as I mentioned early on, when you see conventional commodities break like they have, especially in this space, we have a long track record of being able to call those numbers pretty well.

This year, you know, it didn't quite break that way. When we got past the beginning of the year, farmers were in a new tax [ph] season, silos were full of a lot of organic wheat, and we expected a lot of it to come to market but it didn't. So we were in a shorter position than we would have otherwise liked to have been, which caused us to go back and look at our numbers and make the call that we've made.

So I think it reflects a couple of things. One is, you know, as the organic market continues to grow, in certain areas there's going to be places where organic demand is going to outstrip the growth rate of organic commodity production. It's possible, even though it's a very opaque market, it's hard to see what people have in storage, it's possible that we've gotten closer in that area here. So we need to be more creative and longer-term thinking in terms of the strategies that we're employing, to make sure that we stay far ahead of that. And we've put a number of those in place, which now give us comfort and high visibility through the first half of next year. And over time we think leveraging those, we should see, you know, better performance in terms of buying that commodity. But in general, across our business and others in the space, we need to stay very focused on that, making sure that we're building supply far enough ahead with the visibility that we need to really drive long-term continued growth.

Robert Moskow – Credit Suisse

Okay. Well, thank you for the color.

And lastly, in your prepared comments, Zahir, I think you mentioned that there was a lot of SG&A leverage in the quarter. But on an adjusted basis it's still 28% of sales in the quarter. I just wanted to know what you meant by the SG&A leverage. That SG&A actually came in above my expectations in the quarter.

Zahir Ibrahim

Yeah, sure. So my comments specifically around G&A leverage?

Robert Moskow – Credit Suisse

Yeah.

Zahir Ibrahim

Right. So we talked to, we've invested in people quarter over quarter, and despite that we still saw significant leverage on the G&A line. In the area of sales and marketing, we probably came in higher than expectation, primarily because of the marketing spend, so continue to invest strongly behind our brand and also the frozen platform. So there were good investments.

If you look at our SG&A performance for the year as a whole, it's been very solid. So year-to-date we're delivering over 100 basis points of SG&A leverage. And we'd expect that to continue in Q4 as well.

Robert Moskow – Credit Suisse

Where's the marketing dollars going? Is it direct to consumer or is it something else?

John Foraker

Yeah. Our focus is really delivering great content and connecting with consumers in a highly authentic way with digital social. We've been engaging core and our crossover natural targeted [ph] consumers very actively in this area and getting, we think, very good results for those spends. On a year-to-date basis, first ten months of this year, we've averaged over $150 million media impressions per month for the Annie's brand against targeted consumer. So that's really where it is. It's not in price or conventional media, it's really very focused digital targeting consumers that we want to bring in to the franchise and also increase loyalty with.

Robert Moskow – Credit Suisse

Okay. Thank you.

Operator

Thank you. Our next question is from the line of Jon Andersen with William Blair & Company. Please go ahead.

Jon Andersen – William Blair & Company

Good afternoon. Thanks for taking the question.

John Foraker

Yeah.

Jon Andersen – William Blair & Company

I just wanted to ask about the frozen platform and whether you could give us a little bit more flavor on perhaps kind of consumption trends that you're seeing for pizza in the natural channel in your efforts to build distribution in conventional. And then also on frozen entrée side, I know it's early, but kind of where you sit right now with respect to distribution and what we can expect over the next several quarters. Thanks.

John Foraker

Sure. So first on pizza in the natural channel, we obviously have full distribution at Whole Foods. Outside of Whole Foods, our ACV levels right now are about 55% in the spins [ph] universe, or right about the number three, four brand, we're seeing very strong growth year over year. We have, you know, we're building a really solid repeat customer there and we're seeing that in a number of key retailers in the natural space.

In grocery, we're still looking at the same kind of tactics that we've been executing over the last couple of quarters. We're directing more of the digital marketing that I focused before on the category to generate trial. We've been working to make sure that we did the right stand-up placement in categories, that we're getting better kind of everyday price points with key retailers where we have the ability to work that. And we're seeing good success in that area. We're also continuing to do research around other options for us in pizza for potentially repositioning the items down the road. But we haven't made any decisions in that regard yet.

On entrees, the footprint of distribution right now is largely in the target stores. We're seeing nice builds in those items. Lasagna looks particularly strong, like a real winner. And tons of consumer comments we're getting, you can see many of them on Facebook and in our other social media channels, we're getting a lot of positive feedback. Consumers like the product. We think the repeat rates are very high once we get trial. So we're - we've learned a lot from pizza, obviously, and we're being quite cautious in the way we expand entrees, but what we're seeing, where we are today, we do like. So we're expanding entrees into the natural retailers and into other key grocery retailers which we'll be seeing later this year.

And then as I implied in my remarks, we expect further innovation in the frozen area as well as Soft and Stable [ph] next year.

Jon Andersen – William Blair & Company

I think you, John, in the past, I think you talked about perhaps six or seven different segments which -- within frozen which you'd identified as potential targets. Is that what you're referring to that there may be another category or category entries in fiscal 2015?

John Foraker

That's right. Our messaging around that hasn't changed. We view frozen as a very strategic platform for the brand, mainly because it appeals to a very significant number of naturally inclined consumers who have the income and orientation to buy very high-quality frozen products that meet their needs, and to avoid the conventional ingredients that they find in most of what's out there.

And so, you know, we continue to believe that and we're seeing good results with the initiatives that we've launched so far. We've learned a lot. And we're going to continue to enter into other segments going forward, and frozen is no exception.

Jon Andersen – William Blair & Company

Okay. And just the last one on snacks. You highlighted the innovation in terms of bagged packaging. Can you talk just a little bit more about what the kind of unmet need is, or maybe the opportunity for Annie's in taking the brand in that direction in those category, what you think that'll bring to the snacks business?

John Foraker

Sure. So the biggest opportunity for us in snacks is to get to the kind of package that's got the right shelf selection, assortment and ability for us to drive much deeper distribution in grocery. In grocery, our snacks business has a very low average [indiscernible] just a little over one. All of our business right now has been legacy cardboard boxes which we've been selling since we introduced them to the snack business in 2003. And we've done a lot of consumer work and tested these products, and what moms and parents tell us is that the boxes are fine but they don't reseal the way they want, they don't fit into a purse the way they want, or diaper bags, they don't fit into the center console of their car. So the flexible packaging has a lot of consumer benefits.

The second thing is, by moving in this direction, we're able to get to an entry price point that lowers the barrier to trial, up against the other alternatives that there are in the category. And we're doing that in a way that is favorable to us or at least not dilutive to our margins on our existing portfolio. So we think it gives us the opportunity to put more items on the shelf to create an Annie's brand block in the snacks space which has really never existed before. And when you walk down the aisle of a well-developed mac and cheese retailer for Annie's, you can really see the brand blocks impact and the impact that we're having on the total category growth and the retailer's profitability and growth, and we think we have that opportunity in snacks too.

You know, Cheddar Bunnies and Bunny Grahams are really iconic sub-brands and we have really strong following for those, but we have very little distribution in mainstream, it's one of the biggest opportunities that we've had in the company. And so this gives us the product assortment and the strategy to go after that in a big way.

Jon Andersen – William Blair & Company

Okay. Thanks guys. Good luck.

John Foraker

Thank you.

Operator

Thank you. Our next question is from the line of Mitch Pinheiro with Imperial Capital. Please go ahead.

Mitch Pinheiro – Imperial Capital

Yeah, hey. Good evening.

John Foraker

Hi, Mitch.

Zahir Ibrahim

Hi, Mitch.

Mitch Pinheiro – Imperial Capital

Yeah, hi. So a couple of admin questions. First, could you, you know, you're shipping - your consumption is ahead of shipments. So what's that imply? I mean, are you -- I mean is, you know, retailer inventory is declining, I mean, how can we -- how can we understand that?

Ed Aaron

Hey, Mitch. It's Ed here. So yeah, if you look at our numbers for both the quarter and on a year-to-date basis, our consumption is running a couple of points ahead of our shipments. And if you look historically in kind of prior years, it tends to be a little of the opposite, as you would expect in our business, which grow in distribution, more likely the shipments are a little bit ahead of consumption. This has been a little bit unusual. First half of the year was, as you recall back on our first couple of calls of the year, we saw [ph] inventory reductions at our largest customer. That we didn't see in the third quarter, but we did see something similar from a large retailer in -- that we do business with, which explains the differential in Q3. So it's a little bit unusual in historical context, but we feel very comfortable where inventories are in the channel right now, and we don't have a reason to believe that shipment growth should be significantly different than consumption growth on an ongoing basis.

Mitch Pinheiro – Imperial Capital

Okay.

John Foraker

That's a headwind we've been facing all year and as that cracks over the next year, it ought to be good for us.

Mitch Pinheiro – Imperial Capital

Okay. Was there any gross margin impact from revenue mix?

John Foraker

Nothing significantly different than we had planned.

Mitch Pinheiro – Imperial Capital

So I mean, you know, I think in prior quarters or maybe the last quarter, you know, the fact that the microwavable cups were growing faster, which are maybe a slightly lower margin than your typical mac and cheese, your standard mac and cheese, that's not having -- you sort of catch [ph] that?

Ed Aaron

So, Mitch, we, in terms of the impact of new products on growth this quarter, it was solid. It wasn't quite as impactful as in Q2, which is not all that surprising because Q2 was more of a pipeline fourth [ph] quarter for both cups and frozen entrees. So it was a meaningful contributor to our growth, but just not quite to the extent of what we saw in Q2. And it wasn't -- didn't have a significant impact on our year-over-year gross margin comparisons in the quarter.

Mitch Pinheiro – Imperial Capital

Okay. And then in fiscal 2015, you mentioned investments I guess in infrastructure as something to consider, I guess, you know, when we model. What are we talking about? Is this human capital, IT capital, all of the above? Is it marketing investment?

Zahir Ibrahim

Yeah, I would articulate it as continuing journey that we've been on in fiscal 2014. We're probably not prepared to say much more than that on this call, but we'll go into that obviously in a lot more detail on the next call.

Mitch Pinheiro – Imperial Capital

Okay. And then finally, what type of impact will Easter have? You called it out, but is it a -- can you -- any percentage impact that you could share?

John Foraker

So in prior years when Easter flapped back and forth around the beginning of the fiscal year, we've kind of called out generally like roughly $1 million number. The business is growing and getting bigger now, so that number is inherently growing. And then this year there's about a three-week gap and Easter is significantly later than normal. So we directionally put at around $1 million bucks. But the truth is it's very hard to be very precise about it. But directionally that's certainly in the ZIP codes [ph].

Ed Aaron

And just to emphasize, our expectations from a sales growth standpoint in the fourth quarter, you know, how to change from where they've been all year, so we've been expecting Easter shift to have an impact on our Q4 sales growth and our plan still is like that, in the same way that they have all year.

Mitch Pinheiro – Imperial Capital

Okay. All right. Thank you very much.

Operator

Thank you. [Operator Instructions]

Our next question is from the line of Scott Van Winkle with Canaccord Genuity. Please go ahead.

Scott Van Winkle – Canaccord Genuity

Hi. Thanks. Most of my questions have been asked, so a couple of follow-ups if I could. First, on the wheat commentary and having nine months of visibility, is that more or less than you would normally sit at today versus a year ago, or have you taken a more cautious position or a little shorter than normal thinking as the prices improve in the future?

John Foraker

I'd say it's just a little bit longer than we normally would. We normally would be about that covered, kind of right around the end of our fiscal year. And so I'd say, given the sensitivity to it and just the issues we've been facing recently in that market, we thought that was a smart thing to do, give us really good visibility around it going into next year, so that we can manage the rest of our business right to deliver our objectives.

Scott Van Winkle – Canaccord Genuity

Okay. And then another follow-up is, in the conversation about the introduction of the bagged snacks, is it fair to kind of maybe summarize and say it's incremental in grocery and a natural where you already have strong distribution on the box side, maybe it's not as incremental?

John Foraker

Yeah. The way to characterize it is, in places where our business is already well-developed, it's certainly going to be less incremental. But we do expect it to be incremental, and that is one of the tests that we ran last quarter where we saw a nice lift on our business incrementally.

In places where we're driving the items deeper, expanding assortment and getting into an aversion territory in grocery for the brand where we really haven't had as much main line distribution, it's going to be highly incremental. And there's really very little risk with respect to that profile. We do need to, in any kind of transition like this, we need to be careful we're managing, you know, two different sizes and we need to make sure that we manage the retail assortments for expansion and we have a very focused strategy to do that and we're being very targeted in the retailers that we're going to and working with to make sure that we can deliver that kind of end-result.

Scott Van Winkle – Canaccord Genuity

Great. Thank you very much.

John Foraker

Thank you, Scott.

Operator

Ladies and gentlemen, this concludes the Annie's, Inc. third quarter fiscal 2014 earnings conference call. If you would like to listen to a replay of today's conference call, please dial 1-800-406-7325 or 303-590-3030 and enter the access code 4665678 followed by the pound sign. Those numbers again are 1-800-406-7325 or 303-590-3030 and enter the access code 4665678 followed by the pound sign.

This concludes our conference for today. Thank you for your participation. You may now disconnect.

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